Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.

Sunday, March 22, 2015

How An Estate Can Lose A Charitable Deduction

It happened
again this week. I was speaking with another accountant when he raised a tax
question concerning an “estate” return. My stock question to him was whether it
was an “estate fiduciary” or an “estate estate.” Both have the word “estate” in
it, so one needs further clarification.

What is the difference?

If one dies
with too many assets, then the government
requires one to pay taxes on the transfer of assets to the next person. This is
sometimes referred to as the “death” tax, and I sometimes refer to it as the “estate
estate” tax.

It has
gotten a little more difficult to trigger the federal estate tax, as the
taxable threshold has been raised to over $5 million. That pretty much clears
out most folk.

Then you can
have the issue of the estate earning income. How can this happen? An easy way
is to own stock, or a business – or perhaps a part of a business through a partnership or
S corporation. That income will belong to the estate until the business is
transferred to the beneficiary. That may require a trip to probate court,
getting on the docket, waiting on the judge…. In the interim the estate has
income.

And what do
you have when an estate has income? You have an income tax return, of course.
There is no way the government is not going to grab its share. I sometimes
refer to that tax return as the “estate fiduciary.” A trust is a fiduciary, for
example. The estate is behaving as a fiduciary because it is handling money that
belongs to other people – the same as a trust.

Say that an
estate receives a disbursement from someone’s 401(k). That represents income.
This is usually a significant amount, and Hamilton’s Third Theorem states that
a percentage of a significant number is likely to also be a significant number.
This seems to always come as a surprise when the attorney fires over an estate’s
paperwork – usually very near the filing due date – with the expectation that I
“take care of it.”

Then we are
looking for deductions.

A fiduciary
has a deduction called an “income distribution,” which I rely upon heavily in
situations like this. We will not dwell on it, other than to say that the
fiduciary may be allowed a deduction when he/she writes a check to a
beneficiary.

No, the
deduction I want to talk about today is about a contribution to charity.Does our “estate fiduciary” get a deduction
for a charity? You bet.

Let’s take
this a step further. What if the estate intends to write a check to charity but
it cannot just yet? Can it still get a deduction?

Yep.

This is a
different rule than for you and me, folks. The estate has a more lenient rule
because it may have to wait on a court hearing and receive a judge’s approval
before writing that check. The IRS – acknowledging that this could wreak havoc
on claiming deductions – grants a little leeway.

But only a
little. This rule is known as the “set aside,” and one must meet three
requirements:

(1)The contribution is coming from
estate income (that is, not from estate corpus)

(2)The contribution must be allowed by
estate organizing documents (like a will), and

(3)The money must be permanently set aside,
meaning that the likelihood that it would not be used as intended is
negligible.

So, if we
can clear the above three requirements – and the estate intends to make a
contribution – then the estate has a possible deduction against that 401(k) distribution
that I learned about only two or three days before the return is due.

What can go wrong?

One can flub
the “negligible” requirement.

I cannot
remember the last time I read about a case where someone flubbed this test, but
I have recently finished reading one.

The decedent
(Ms Belmont) passed way with a quarter million in her 401(k) and a condo in
California. She lived in Ohio.

Alright,
there is more than one state involved. It is a pain but it happens all the
time.

Her brother
lived in the condo. He was to receive approximately $50,000, with the bulk of
the estate going to charity. He was under mental care, so there may have been a
disability involved.

How can this
blow up? Her brother did not want to move out of the house. He offered to
exchange his $50,000 for a life estate. He really wanted to stay in that house.

The charity
on the other hand did not want to be a landlord.

Her brother
brought action and litigation. He argued that he had a life estate, and he was
being deprived of his contractual rights. He filed with the Los Angeles County Probate
Court and the California Recorder’s Office.

Meanwhile
the estate fiduciary return was due. There was a big old number in there for the
401(k) distribution. The accountant – who somehow was not fully informed of developing
events in California – claimed a charitable contribution deduction using the “set
aside” doctrine.

The California
court decided in the brother’s favor and orders a life estate to him and a
remainder deed to the charity.

The estate thinks
to itself, “what are the odds?” It keeps that set aside deduction on the estate
fiduciary return though.

The IRS
thinks otherwise. It points out that the brother was hip deep by the time the
accountant prepared the return, and the argument that risks to the set aside
were “negligible” were unreasonable when he was opening up all the guns to
obtain that life estate.

The estate lost
and the IRSwon. Under Hamilton’s Third
Theorem, there was a big check due.

What do I
see here? There was a tax flub, but I suspect that the underlying issue was non-tax
related. Likely Ms Belmont expected to outlive her brother, especially if he
was disabled. It did not occur to her to plan for the contingency that she
might pass away first, or that he might contest a life estate in the house
where he took care of their mom up to her death while his sister was in Ohio.

About Me

Thirty years years in tax practice. It's a long time, and I have seen virtually everything short of the fabled tax-exempt unicorn. I was raised in Tampa, went to school in Missouri, taught at Eastern Kentucky University, lived in Georgia, got pulled to Cincinnati when I married, have in-laws in England and a daughter going to the University of Tennessee. I am not sure where I will wind up next, but I hope there is better weather.